Monthly Archives: April 2017

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The Government Accountability Office (“GAO”) issued a report on four types of financial technology (“FinTech”): marketplace lending, mobile payments, digital wealth management (also known as “roboadvisor”), and distributed ledger technologies (“DLTs”) such as blockchain. The GAO addressed functionality, risks and benefits, industry trends, and regulatory oversight.

The GAO did not make specific recommendations concerning oversight, noting that very little commonality exists between the differing types of FinTech. However, the GAO acknowledged the challenges involved in regulating FinTech:

“With respect to virtual currencies, federal and state regulators have taken varied approaches to regulation and oversight. The existing regulatory complexity for virtual currencies indicates that regulatory approaches for future applications for DLT will also be complex.”

Lofchie Comment: The GAO report serves as a good introduction to each of the four FinTech subsectors, and to some of the more significant legal and compliance issues that each business raises.

Federal Reserve System (“FRB”) Governor Jerome Powell reviewed the regulatory response to the global financial crisis and offered his perspective on the state of current financial market infrastructure and possible regulatory adjustments going forward.

In a speech before the Global Finance Forum, Mr. Powell praised those who aggressively responded to the financial crisis as having prevented another depression. At the time, he noted, the two primary tasks were to “get the economy growing again” and address the “many structural weaknesses” in the financial system. Mr. Powell noted that while job growth has been strong and the U.S. has not had another recession, there has been a labor productivity slowdown associated with “weak investment and a decline in output gains from technological innovation.” To address this, Mr. Powell called for a “national focus on increasing the sustainable growth rate of our economy.”

Mr. Powell stated that the financial system has improved and stabilized primarily because of (i) higher levels of quality capital held, (ii) higher levels of liquidity held, (iii) capital stress testing, (iv) resolution planning (i.e., living wills), and (v) the “greater transparency and more consistent risk management” that comes with the central clearing of interest rate and credit default swaps. He argued that these core reforms should be protected, but called for certain regulatory adjustment in instances where new regulations have been inappropriately difficult for smaller firms or otherwise inefficient, adding:

“Some aspects of the new regulatory program are proving unnecessarily burdensome and should be better tailored to meet our objectives. Some provisions may not be needed at all given the broad scope of what we have put in place. I support adjustments designed to enhance the efficiency and effectiveness of regulation without sacrificing safety and soundness . . .”

Lofchie Comment: Mr. Powell joins a steadily increasing number of regulators who are conceding that Dodd-Frank has had some material negative effects. These concessions lay the groundwork for a rational discussion of how financial regulation may be improved – a welcome change from eight years in which “improvement in regulation” and “more regulation” were purported to be synonymous concepts.

In two executive memoranda, President Donald J. Trump directed the U.S. Department of the Treasury to review key elements of the Dodd-Frank post-crisis regulation. The memoranda authorizes the Treasury Secretary to review (i) the processes of the Financial Stability Oversight Council (“FSOC”) for designating “systemically important” institutions, and (ii) the Orderly Liquidation Authority (“OLA”) including a review of potentially adverse consequences posed by the framework.

In a statement, Treasury Secretary Steven Mnuchin said that during the review process, the Treasury will not designate any new non-bank financial institutions as systemically important under the FSOC. The goal of the review, he said, is to “make this a smarter, more effective process that reduces the kinds of systemic risk that harmed so many Americans during the financial crisis of 2008.”

Secretary Mnuchin said that the review of the OLA will attempt to determine (i) whether the OLA is encouraging “inappropriate risk-taking,” (ii) “the extent of taxpayer liability,” and (iii) how the bankruptcy code “may be a more appropriate avenue of resolving financial distress.”

Lofchie Comment: Politically, these executive actions are promoted as being for the purpose of holding Wall Street accountable. The larger benefit they provide is to put a check on the very broad discretionary powers afforded the government under Dodd-Frank. These executive actions move financial regulation back toward a system of rules governed by written procedures and not by grants of broad discretion.

House Republicans released the Financial CHOICE Act of 2017. The bill is an update of the CHOICE Act of 2016. The new version represents a major overhaul of the current financial services regulatory regime including a partial repeal of Dodd-Frank.

In September 2016, the House Financial Services Committee approved the initial version of the CHOICE Act by a vote of 30 to 26. At a hearing scheduled for April 26, 2017, the Committee will discuss the updated version of the bill. Proposed changes to the current financial regulatory regime include, among other things:

an opt-out of many regulatory requirements for banks and other financial institutions if they maintain a 10% leverage ratio (among other conditions);

Regarding derivatives, the new legislation exempts certain inter-affiliate swaps from nearly all Title VII requirements (except reporting), and otherwise removes a number of changes to Title VII that were previously included (it is suggested that this is because such provisions would be addressed in CFTC reauthorization legislation).

Chairman Jeb Hensarling (R-TX) called the bill a solution that “grows our economy from Main Street up.” He asserted that the CHOICE Act is premised on the principles that all banks need to be well-capitalized and that community banks and credit unions deserve relief from the “crushing burden of over-regulation.”

Lofchie Comment: Changes that the bill would make in the regulatory process are genuinely significant. These are largely in Title III of the proposal (see page 104).

Under the terms of the bill, the various financial regulators (including the banking regulators, the CFTC and the SEC) would be prohibited from issuing a “regulation” (which term would be broadly defined) unless the regulator first issued a statement (i) stating the need for the regulation, (ii) explaining why the private market could not address the problem, (iii) analyzing the adverse impacts of the regulation, and (iv) attempting to quantify the costs and benefits of the regulation, including its effects on economic activity, the basis for its determinations, and, most significantly, “an explanation of predicted changes” that will be brought about by the regulation. A final rulemaking would be required to include “regulatory impact metrics selected by the [regulator’s] chief economist.”

Adherence to this process would make the tasks of the regulator materially more difficult, or at least it would make it more difficult for the regulators to pass rules. Of course, there is a significant amount of good in that. Regulators should be subject to a reasonably high burden of consideration in adopting rules that may cost market participants, in the aggregate, millions of dollars in compliance costs or that have negative effects on the economy generally.

One of the most interesting provisions of the bill is the requirement that regulators should provide an explanation of predicted changes that will result from the rule. Doubtless, in many cases, the predictions will turn out to be wrong. But that is ok. It is unreasonable to expect that regulators will be always, or even that consistently, correct in their predictions. The new standard may be hard to assess, but the attempt is still worthwhile.

The Consumer Financial Protection Bureau (“CFPB”) published its fifth Fair Lending Report. The CFPB highlighted its efforts to protect consumers from market abuses, as well as its remediation results and priorities for 2017.

The report identified a number of approaches and outcomes related to the CFPB’s 2016 fair lending initiatives, including:

risk-based prioritization in supervisory and enforcement work,

results from enforcement actions, which produced $46 million for consumers,

an update on Regulation C (“Home Mortgage Disclosure”) and the CFPB’s dialogue with the industry regarding compliance,

interagency efforts to ensure the active supervision and enforcement of the fair lending laws and regulations, and

CFPB Director Richard Cordray said that the three goals of the Bureau in this area are to “strengthen industry compliance programs, root out illegal activity, and ensure that harmed consumers are remediated.” He praised the CFPB’s “significant efforts,” and added that the Bureau had reached an “historic resolution” of large cases involving redlining, auto finance and credit card fair lending.

CFPB Office of Fair Lending and Equal Opportunity Director Patrice Alexander Ficklin reported that in 2017, the Office will strengthen its focus on redlining and mortgage, student loan servicing, and small business lending.

Lofchie Comment: Given that many of the CFPB’s actions do not reflect current executive or legislative policy, the CFPB’s report on the direction of its intended activities brings home a difficult Constitutional issue: to what branch of the government does the CFPB belong? It is not judicial. It is not funded directly by Congress. And it does not report to the President. It is clearly more “independent” than the other independent agencies, such as the SEC or the CFTC (whose Chairpersons are named by the President), but its extreme independence forces the question of where independent agencies (including even the SEC and the CFTC) fit generally within the Constitutional scheme of a tripartite government.

Today we release CFS monetary and financial measures for March 2017. CFS Divisia M4, which is the broadest and most important measure of money, grew by 4.0% in March 2017 on a year-over-year basis versus 4.1% in February.

The FDIC released a semi-annual report of the Global Capital Index. FDIC Vice Chair Thomas Hoenig described the results, noting that equity capital ratios increased at most of the largest U.S. banks.

Vice Chair Hoenig maintained that, while the report reveals improvements in capital ratios, the banking sector remains highly leveraged and provides the lowest return on equities when compared with other major U.S. industries. He expressed concern that capital ratios at the largest U.S. banks “remain too low,” which is “undermining long-term economic growth.”

Lofchie Comment: The notion that banks would improve their return on equity if they had a higher percentage of equity seems counterintuitive. The “proof” that Vice Chair Hoenig offers for this assertion is that other industries that have higher ROEs are less highly leveraged. The argument that a bank would make the same profits as a consumer/discretionary company if only it had the same debt/equity ratio does not seem compelling. There are reasons other than high leverage why banks’ ROE might be low: for example, heavy regulatory costs and being forced out of existing business activities; e.g., the Volcker Rule. Perhaps Vice Chair Hoenig’s theory is correct, but other possible theories should be considered.

The Bank for International Settlements (“BIS”) published a Report that found that changes in the availability and cost of repurchase agreement (“repo”) financing are affecting the ability of repo markets to support the financial system. The Report was prepared by a study group organized by the BIS Committee on the Global Financial System (“CGFS”) that included staff members from international regulatory agencies, the Board of Governors of the Federal Reserve System and the New York Fed.

The study group examined repo transactions backed by government bonds and concluded that banks in some jurisdictions appear to be less willing to undertake repo market intermediation than they were before the crisis. Key “drivers” behind these changes include “exceptionally accommodative monetary policy” and regulatory changes that have made intermediation more costly. However, the study group cautioned that it would be premature to establish correlations between policy changes and changes in the market given “differences in repo markets across jurisdictions and the fact that repo markets are in a state of transition.”

To improve repo market functioning, the study group recommended that a series of temporary measures be implemented, including steps to reduce the “scarcity of certain collateral.”

In his parting speech as a member of the Board of Governors of the Federal Reserve System (“FRB”), Governor Daniel K. Tarullo asserted “that strong capital requirements are central to a safe and stable financial system.” He described the post-crisis atmosphere in which regulatory capital requirements were first proposed, and evaluated the subsequent adoption of the Dodd-Frank Act. Noting that a statute as broad as Dodd-Frank could not possibly get everything right, Governor Tarullo cited the Volcker Rule as an area where the “case for change has become fairly strong”:

[T]he Volcker rule is too complicated. Achieving compliance under the current approach would consume too many supervisory, as well as bank, resources relative to the implementation and oversight of other prudential standards. And although the evidence is still more anecdotal than systematic, it may be having a deleterious effect on market making, particularly for some less liquid issues.”

Governor Tarullo identified the following flaws in the Volcker Rule: (i) it involves five regulatory agencies, (ii) it contemplates evaluating the mindset of a trader at the time a trade is made, and (iii) it applies to a much broader group of banks (including community banks) than necessary.

Governor Tarullo championed the “risk-based” capital approach as the best post-crisis capital buffer, noting that no single measure of capital would be appropriate. He advocated moving toward a simpler approach for community banks and rejected a recent proposal to implement a broad leverage ratio, increased to 10 percent, as a substitute for existing regulation. He argued that a higher leverage ratio would “make banks less profitable, and . . . they would be strongly incentivized to change the composition of their balance sheets dramatically, shedding safer and more liquid assets” if the new ratio became the predominant regulatory feature.

Governor Tarullo also evaluated the unfinished “transition of stress testing from crisis program to a permanent feature of prudential oversight.” He stated that for stress testing to succeed, it must evolve along with the financial system. He opposed removing capital distributions from the stress-test regime claiming that it would result in fewer protections for the financial system.

CFTC Acting Chair J. Christopher Giancarlo appointed Andrew B. Busch Chief Market Intelligence Officer. Mr. Busch will lead the new Market Intelligence Unit which is designed “to understand, analyze and communicate current and emerging derivatives market dynamics, developments and trends – such as the impact of new technologies and trading methodologies.” The position is a first for the agency. Mr. Bush will start on April 10, 2017. Acting Chair Giancarlo explained that:

“[t]he new Chief Market Intelligence Officer . . . will help activate the CFTC’s latent capability for market intelligence, giving us better insight into the needs of participants in the futures and swaps we oversee.”

Previously, Mr. Busch founded and served as CEO of the boutique economic research company, Bering Productions, Inc.